Why The Greece Episode Means More Inflationism

``The European capital market institutions would not be able (or even willing) to step up to the plate and negotiate a restructuring. The ECB is not allowed to. And the EC is not up to it. There is an alternative -- the IMF has specific experience in this regard. But, allowing the IMF in would be an admission that the Euro area has not quite made it as currency union. The IMF, given its historical origin with exchange rate mechanisms, would convey a message that the big Euro players would not like to see. It would tar the reputation of the Euro even if there are no contagion effects on other PIIGS. Moreover, allowing Greece out of the Euro (or kicking) it out would be even worse. That is why, I think, the Germans will pay up. They will pay to maintain the reputation of the Euro. Americans underestimate the commitment to the Euro.” –Paul Wachtel Thoughts on Greece's debt problems

Prior to last week’s intermission, we noted that like the Dubai debt crisis, the Greek dilemma would seem like a political issue more than an economic one and therefore, as we suggested, would be resolved politically.

And by politically, we meant that arguments for sound policies or by imposing harsh or rigorous discipline against a wayward member of the EU would be subordinate to the practice of inflationism.

And as per the mainstream, the most recent volatility in the global markets had been mostly attributed to either the prospects of a contagion from the risks of a Greece default or from the attempts of China to wring out inflation out of its system.

Nevertheless, we have not been convinced by verity of the alleged cause.

While key benchmarks across asset markets have indeed broadly deteriorated then, which somewhat did raise some worries on my part, the correlation and the supposed causation did not seem to square [see Global Market Rout: One Market, Two Tales].

If indeed there had been a generalized anxiety over a contagion of rising default risks from sovereign debts, then sovereign CDS AND sovereign YIELDS, aside from corporate and bank lending rates would have spiked altogether!

In addition, considering the scenario of a run from sovereign securities, the contagion should have been largely a regional dynamic and paper currencies would not have been seen as the safe shelter, since the major currencies of the world have all similarly afflicted by the same disease!

What happened instead was a palpable shift to the currency (US dollar) of the lesser affected nation (the US) which somewhat resembled a “flight to safety” paradigm of 2008. With the trauma from the recent crisis along with automatic stimulus response [as discussed in What Has Pavlov’s Dogs And Posttraumatic Stress Got To Do With The Current Market Weakness?] some have mistakenly labeled the recent events as the unwinding US dollar carry trade.

Yet, as CDS and yields went on the opposite course, Baltic stock markets soared and gold plummeted validating our observation that the precious metal, which has served as man’s money throughout the ages, has been exhibiting a tight correlation with the Euro or a proxy thereof, instead of deflation or inflation signs [see When Politics Ruled The Market: A Week Of Market Jitters]. This tight correlation appears to have been broken last week! (see figure 3)

Figure 3: stockcharts.com: Gold-Euro Break, US 10 Year Yield, JP Morgan Emerging Debt Fund

The contour of the Euro and Gold trendlines has been the same over the 6 months up until last week!

Since gold has served as lead indicator of asset markets since the depths of 2008, including the recent selloffs, any resumption of an upward trend by gold is likely to be signs that asset markets will be headed higher soon.

Ergo, Gold above 1,120 should likely serve as my trigger for a buy on equity markets.

Moreover the major US sovereign benchmark, the 10 year Treasury yield (TNX), in spite of the recent stock market setback has remained stubbornly high. Also the JP Emerging Market Debt Fund (JEMDX), in spite of the recent China and Greek jitters, remains buoyant.

In other words, those expecting a repeat of 2008 or of a deflation scenario appear to be in a wrongheaded direction.

What seems to be in place is that the markets seem to be looking for a reason to retrench or has been reacting to the discordant tones from the mixed messages transmitted by the political and bureaucratic authorities. In short, if markets had been recently buoyant out of a flood of global liquidity then qualms over a liquidity rollback appear to be the major concern.

Inherent Defects In The Euro

Any major liquidity rollback for developed economies would most likely be deferred, with the Greek and the PIIGS issues signifying as one of the principal reasons.

Remember since the PIIGS is a political issue then any attempt to resolve the Greek crisis will be political.

Professor Paul Wachtel in a New York University forum captures it best, ``It is not Greece, it is the Euro. A troubled small country can be shrugged off but a currency area is either whole or not. The Germans will pay up to keep the Euro area in tact.”

True. A united Europe has been a longstanding project since the close of World War II. Monetary integration has been in the works through the European Monetary System since March of 1979.

So the Euro isn’t just a symbolical currency that can easily be jettisoned, instead it is a sense of pride for the major European economies that make up the core of the European Union. Hence it won’t be easy to dismantle a pet project for Europe’s social democrats.

However since the Euro is another monetary experiment it comes with inherent flaws in it.

For instance, the inclusion of Greece to the European Union has effectively bestowed subsidy privileges to her by the European Central Bank (ECB) even prior to this crisis via an intraregion carry trade.

Where the interest rate spread of Greek sovereign instruments had been wide relative to core Euro members, European banks bought Greek bonds and used them as collateral to extract additional loans from the ECB. Spendthrift socialist Greece, in turn, took advantage of this easy access to money to fund lavish public expenditures.

As Philip Bagus explains, ``The banks buy the Greek bonds because they know that the ECB will accept these bonds as collateral for new loans. As the interest rate paid to the ECB is lower than the interest received from Greece, there is a demand for these Greek bonds. Without the acceptance of Greek bonds by the ECB as collateral for its loans, Greece would have to pay much higher interest rates than it does now. Greece is, therefore, already being bailed out.

``The other countries of the eurozone pay the bill. New euros are, effectively, created by the ECB accepting Greek government bonds as collateral. Greek debts are monetized, and the Greek government spends the money it receives from the bonds to secure support among its population.”

The latest US centered bubble exacerbated the carry trade and the intraregion subsidies of the PIIGS which eventually rendered European banks as highly sensitive to a PIIGS default (see figure 4).

Figure 4: Bloomberg: Shot Gun Wedding

According to Bloomberg’s Chart of the Day, ``Banks in Germany and France alone have a combined exposure of $119 billion to Greece and $909 billion to the four countries, according to data from the Bank for International Settlements. Overall, European banks have $253 billion in Greece and $2.1 trillion in the so-called PIGS.”

So not unlike the US, the European Union will most likely persist in subsidizing subprime PIIGS and the European banking system at the expense of the rest of its society.

And also not different from the US, the risks of unsustainable welfare states will likely be a part of the currency and asset equation.

NYU’s Mario Rizzo bluntly writes, ``People like to deny reality when it is unpleasant. This is not just a problem of bad leadership. It is a problem that goes to the heart of the fantasy world the typical voter lives in. Buy reality bites. Let’s see how it does so in the next few years.” (bold highlight mine)

Moreover, the underlying systemic subsidies incent European member state beneficiaries to expand spending. Obviously such feedback loop mechanism of incremental subsidies and deficit spending will ultimately be untenable.

Again from Philip Bagus, ``For the member states in the eurozone, the costs of reckless fiscal behavior can also, to some extent, be externalized. Any government whose bonds are accepted as collateral by the ECB can use this printing press to finance its expenditures. The costs of this strategy are partly externalized to other countries when the newly created money bids up prices throughout the monetary union.

``Each government has an incentive to accumulate higher deficits than the rest of the eurozone, because its costs can be externalized. Consequently, in the Eurosystem there is an inbuilt tendency toward continual losses in purchasing power. This overexploitation may finally result in the collapse of the euro.” (bold emphasis mine)

So perhaps it wouldn’t be systemic rigidities that could undo the Euro, as preeminent monetarist Milton Friedman warned about [or the tradeoff between ``greater discipline and lower transaction costs outweigh the loss from dispensing with an effective adjustment mechanism”] but the untenable cross subsidies and systemic inflationism inherent within the system.

Easy Monetary Policies To Continue

And the political response has been as what we had expected.

An article from Bloomberg says Europe will use former US Treasury Secretary Hank Paulson’s “Bazooka” approach to deal with Greece, ``European leaders closed ranks to defend Greece from the punishment of investors in a pledge of support that may soon be tested. German Chancellor Angela Merkel and her counterparts yesterday pledged “determined and coordinated action” to support Greece’s efforts to regain control of its finances. They stopped short of providing taxpayers’ money or diluting their own demands for the country to cut the European Union’s biggest budget deficit.”

Like short selling, the blame has always been pinned on the markets. However, as discussed above, the woes of the PIIGS exhibits a structurally flawed monetary system.

The fact that Greece fudged its numbers to get into the Euro membership serves as damning evidence of EU’s incompetence. Investors don’t just punish nations without any basis. Investors get burned for making the wrong decisions.

On the other hand, bilking taxpayers, misrepresentation and mismanagement are enough justifications for punishment, not only from investors but from the resident political constituency. True, international sanctions won’t likely work as policymakers are too tied up rescuing each other.

Of course, tightening of monetary policies today won’t help the cause of the EU or the US from executing bailouts and rescues of their political patrons. Hence we can expect deferred “exit strategies” and even extended quantitative easing programs.

Oh, did I just mention the US as possibly help fund a Greece bailout? Yes, apparently. This according to Financial Times, `` European governments are expected to turn increasingly to US investors to help them meet their funding requirements as record levels of bond issuance make it harder to attract buyers.” (bold highlight mine)

So whether it be the IMF (where the US has the largest exposure representing 17% of voting rights) or direct participation from US investors we can expect somewhat the US to be a tacit part of the rescue team. Sssssssshhhhh.

Perhaps, some Asian nations as China may take part in it too.

What do you expect, it’s a paper money system! Government central banks can simply print money and channel them into sectors or economies in dire straits, in the hope that the money printing has neutral effects.

All the imbalances we’ve just spelled out here is a medium to long term perspective, which means they aren’t likely to unravel anytime soon.

But it is one of the risks that should be reckoned with overtime.

For the meantime, the triumphalism of the Philosopher’s Stone or the alchemy of turning lead into gold will likely still work its interim or immediate wonder. That’s why it has been the preferred du jour priority option by policymakers.

And importantly, that’s why it gives confidence to the global political authorities to do all their redistributive programs.

Meanwhile, expansionary policies from the EU and the US are likely to continue. And this should help support the asset markets.

A China Bubble Bust Is Unlikely Yet

``I write this piece to warn against the simplistic notions about China that permeate our media, and to challenge the powerful special interests that want to paint China as a nation to be attacked, not vigorously debated. We face a long and very challenging dialogue with China, and I believe knowledge is an infinitely better negotiating tool than crude propaganda and simplistic nationalism. Am I really saying China should be handled differently? No, just intelligently.” Mark W. Headley In China’s Shoes, Matthews Asia

Well the other main source of concern is no less than China.

Bears have been growling out louder about an imminent bubble bust in China.

As we wrote in China’s Attempt To Quash Its Homegrown Bubble and in China's Bubble And The Austrian Business Cycle, while we agree with the notion that China have been undergoing a bubble process, since most of the symptoms have manifested the typical Austrian Business cycle model, it is quite unclear that that they’ve reached a manic or terminal phase.

Besides, bubbles do not imply an immediate bust. Bubbles operate as a cycle, where it undergoes several phases. A busting bubble is the end game of the terminal or manic phase.

And betting against an imploding bubble requires some timing. Betting too early before the full stretch of the manic phase would leave shorts without underwears.

Mixed Bubble Signals

Figure 5: WSJ/US Global: Mixed Picture

Yes it is true that property prices and loans have meaningfully surged (see figure 5 left window from Wall Street Journal) enough to prompt for many to yell “fire!”, but it also would seem possible that the surge in property prices could have been reflecting on the pace of the increase in the per capita income of the population (see right window: US Global Fund), albeit the speed may have been quite too drastic.

And in the light of the dramatic expansion of loan and property prices, China reportedly is scheduled to raise its reserve requirements by 50 basis points on her banking system for the second time this year by next week (February 25^th).

As to the success of a soft landing from China’s attempt to quash her homegrown bubble is yet unclear. A more significant but adverse impact would be a continuing trend of falling asset markets and imploding malinvestments within the economy. This has not yet emerged.

Figure 6: Bloomberg: Shanghai (top) and Shenzhen (below) Stock Markets Seem Stabilizing

So far, China’s stock markets appear to be stabilizing following the repeated assaults by China’s government to control her bubbles.

Both the Shanghai and Shenzhen benchmarks seem to be bottoming in spite of the recent news to tighten lending. This is in sharp contrast to the violent responses seen in both benchmarks last January.

Have China’s stock markets been turning blasé or discounting the government actions? Or has this been a proverbial calm before the storm? Does this also imply that China’s bubbles are now confined to the property sector?

From my observation of the bubble cycles, bubbles have wide spillover effects. They tend to raise asset prices in general but with most of the impact seen on the areas where the malinvestments have been concentrated. This implies that a full pledge bubble should also be manifested in the stock markets.

This does not seem to be happening in China.

Why Stereotyping Misleads

It isn’t easy to read China. She hasn’t been as transparent and the accuracy of her statistics is likewise in doubt.

However, in my view, opaqueness doesn’t justify macro based heuristics to pass negative judgments. That’s because inaccuracy can work both ways: underestimation and overestimation. The bearish camp believes the latter.

Yet, the fact that China has entered into a free trade agreement with ASEAN and the other East Asian neighbors should be seen significantly in the positive light [see Asia Goes For Free Trade].

It would even be a flagrant mistake to compare China to a particular stock or a company.

Corporations are not like economies, the former operates on a profit and loss incentive while the latter functions on a highly complex but interrelated self-operating multiple parts composed of acting people. [see The Myths Of Government’s Managing The Economy]

As Jeffery Tucker of Mises.org explains, ``Society works not because a single mastermind has preset all the moving parts. It works because people find ways to cooperate through private actions that follow signs and rules that cannot be anticipated but can nonetheless be coordinated. Society and its workings cannot be mapped out and the attempt to do so can create frameable images but not civilizations.” (bold highlight mine)

Besides, China’s property markets isn’t anywhere like the US. For instance, the Chinese buy properties with sizeable upfront equity.

Shaun Rein in Forbes writes, ``when buying residential properties, consumers in China have to put down 30% before taking out a mortgage. For a second home, they have to put down 50%, no matter what their net worth.”

In addition, income in China has reportedly been underestimated, again Mr. Shaun rebuts China skeptics, ``If anything, incomes are grossly underreported in China. A simple look at how accounting works will show why. Whereas in the U.S. individuals must report their income to the Internal Revenue Service every year, in China all individual tax is reported and paid for by companies, except for that of high earners. Many Chinese companies limit the tax they pay by reporting low salaries and then paying their employees higher amounts while accounting for the difference as business expenses like phone bills. The employees are happy because they make every bit as much as they were promised, and the companies are pleased to lower their tax exposure.”

``Also, many companies pay for housing and cars for their employees, a holdover from the old system of state-run businesses. Most Western economists don't count those expenses as income, but they should. Deceptive accounting of income is so widespread that the government has announced plans to tax some business expenses in state-run enterprises--the kinds of expenses that let executives pay taxes on earnings of $300 a month while living in multimillion-dollar homes and driving Mercedes.” (all bold highlights mine)

As one can observe, comparing a society to another by simply stereotyping can lead to serious misappraisals.

So perhaps we’d stick to the actions in the stock markets, property and bond markets, interest rates and inflation, aside from sentiment indicators as the Art market and the Skyscraper Curse to identify signs of the whereabouts of the bubble cycle.

Nevertheless, China would have a lot of flexibility to deal with an imploding bubble given her inherent financial advantages.

Doug Noland of Prudent Bear’s Credit Bubble Bulletin rightly observes, ``First of all, authorities are sitting on an incredible war chest of $2.4 TN of reserves. This hoard today provides virtually unlimited capacity to recapitalize its vulnerable banking system. This hoard also provides unusual protection against a run on the Chinese currency. Never, it seems, has a Credit system enjoyed such flexibility to run so hot for so long. At this point, I have to believe that the policy objective is not to rein in excess as much as it is to slow bank lending to what is believed to be a more sustainable $1.1 TN annual pace.”

In short, the economies of scale from massive surpluses matters, I’d like to add her savings too.

Considering all these variables, I wouldn’t bet on the imminence of a bubble bust. Perhaps not this year.

US Manufacturing Update: Separating Fact From Fiction

Here is a very interesting update on the state of US manufacturing.

Guess what? Contrary to mainstream expectations, US manufacturing has once again regained the world's supremacy.

This quote from Business Insider's liberal author, Mr. Vicente Fernando who calls it, ``American Manufacturing Making A Mockery Out of Skeptics" (bold emphasis mine)

Mr. Fernando quotes Noah Weisberg @ Goldman: "And within that global cyclical recovery, it may come as a surprise to many that the US is not obviously lagging – what Exhibit 3 shows is that the US manufacturing ISM index level is now among the highest across the world, higher than Europe, but also higher than BRICs. In other words, at least for the time- being the US manufacturing recovery is among the paciest, and the most recent round of quarterly earnings results also seemed to support this with both domestically and globally exposed companies reporting solid results."

"The U.S. ISM is shown by the thin purple line below, which has risen higher than even the BRICs (the dotted black line)."

"Hate to deliver good news, but last week, the U.S. ISM manufacturing index blew away expectations and generally killed it."

"While high U.S. unemployment remains a pressing problem, investors need to differentiate between leading and lagging economic indicators. Yes, there are a lot of economic data sets out there with dubious predictive value, but the ISM manufacturing index is one of best regarded and most reliable leading indicators for the U.S. economy. Employment, meanwhile, is a lagging indicator -- it improves way after everything else does. (Which is of course unfortunate for those who are unemployed, who must wait)."

Well this is should be a reminder for those who subscribe to the reductionist perspective, which tends to tunnel onto a single or select variables (e.g. wages), usually glosses over other very important and relevant interactive factors, especially in a highly complex economy as today. Hence generalizations premised on these frequently leads to wrong conclusions.

For purposes of additional discussion, here is Professor Mark Perry on the alleged but exaggerated state of "depressed" US manufacturing.

Manufacturing’s Death Greatly Exaggerated

By Mark J. Perry

(all bold emphasis and underscore mine)

Here’s some pretty grim news about the U.S. manufacturing sector—manufacturing employment in the United States fell below 12 million this year for the first time since 1946, and is now at the lowest level (11,648,000 manufacturing jobs in November) since March of 1941 (see chart, data here). Since the recession started in December 2007, manufacturing employment has fallen for 24 consecutive months, as the U.S. economy shed an average of 89,000 manufacturing jobs each month for the last two years. From the peak manufacturing employment of 19.5 million jobs in 1979, the American manufacturing workforce has shrunk by more than 40 percent, as almost 8 million manufacturing jobs have been eliminated over the last 30 years, with almost 6 million of those losses taking place just since 2000. And there’s nothing to suggest that the trend won’t continue, so we can expect even more manufacturing job losses in the future.

But here’s where the news about the manufacturing sector gets a little better. According to the Federal Reserve, the dollar value of U.S. manufacturing output in November was $2.72 trillion (in 2000 dollars), which translates to $234,220 of manufacturing output for each of that sector’s 11.6 million workers, setting an all-time record high for U.S. manufacturing output per worker (see chart below). Workers today produce twice as much manufacturing output as their counterparts did in the early 1990s, and three times as much as in the early 1980s, thanks to innovation and advances in technology that have made today’s workers the most productive in history. So at the same time that manufacturing employment has been declining to record low levels, manufacturing output keeps increasing over time, and the amount of output that each manufacturing worker produces keeps rising almost every month to new record high levels.

And here’s some more good news. For the year 2008, the Federal Reserve estimates that the value of U.S. manufacturing output was about $3.7 trillion (in 2008 dollars), and the nearby chart shows how the U.S. manufacturing sector compares to the entire Gross Domestic Product of the world’s five largest non-U.S. economies in 2008 (data here): Japan ($4.9 trillion), China ($4.3 trillion), Germany ($3.7 trillion), France ($2.9 trillion), and the United Kingdom ($2.7 trillion). Amazingly, if the U.S. manufacturing sector were a separate country, it would be tied with Germany as the world’s third-largest economy.

Bottom Line: As much as we hear about the “demise of U.S. manufacturing,” how we are a country that “doesn’t produce anything anymore,” and how we have “outsourced our production to China,” the U.S. manufacturing sector is alive and well. Despite declines in employment, the productivity of manufacturing workers has never been higher, and the United States is still the world’s largest manufacturer."

End quote

My additional Comments:

Let me add that if people buy for different reasons, not limited to the lowest prices with other considerations such as quality, familiarity or trust in the provider or brand, reputation (social status), social motives (charity, gifts, donation), keeping up with the Joneses', charisma of the salesperson and etc..., the obverse side is that investors don't invest only because of low wages. Otherwise we'd see Zimbabwe and African nations as the largest exporters or manufacturers, since they have the cheapest currencies due to the lowest standard of living which redound to the lowest labor costs.

On the other hand, there are many other factors that determine investments; particularly hurdle rate, access to finance or credit, access to capital, access to workers, access to markets, access to raw materials, access to energy, access to information or connectivity, transportation costs, security of property rights, transaction costs, political stability, labor productivity, labor skills, labor hiring and firing statutes, tax rates, legal or regulatory compliance costs or burdens, sanctity of contracts, economic freedom and others.

World bank classifies some of them into the cost of doing business (see methodology in link).

Essentially you can classify them into comparative advantages and division of labor.

And guess what? The common characteristics of these top exporters other than China is that they are highest ranking in terms of the global standings in economic freedom (heritage) and have also the lowest costs in doing business (World Bank).

Mental shortcuts are favorite instruments for the conveyance of political propaganda/manipulation, ergo we should be leery of them.

McKinsey Quarterly: 5 Popular Myths of Jobs Creation

McKinsey Quarterly's James Manyika enumerates the 5 popular myths about how to create jobs in the US

Quoting Mr. Manyika, (bold highlights mine) [comments mine]

1. Surely there’s a quick fix.

Oh, were that only the case. The scale of the challenge is enormous. Quick action is important, but remember that the US economy has lost more than 7 million jobs in the past two years. The country would need to create more than 200,000 net new jobs each month for the next seven years to get unemployment back to what was once considered a normal 5 percent. Quick fixes focused on 2010 alone won’t be enough.

Of course, the right mix of government policies can help. But even if Obama’s proposals were enacted right away and they accomplished all that he hopes, they would at best represent a good start. America’s jobs challenge is a multiyear marathon, not a sprint.

2. The key to boosting employment quickly is to help small businesses.

New jobs come from both small and big businesses. From 1987 through 2005, nearly a third of net new jobs were created by businesses that each employed more than 500 workers. By 2005, these big companies accounted for about half of the country’s total employment, although they made up less than 1 percent of all US firms.

But a look at the past two economic booms shows that the pace of job creation depends on more than the size of the businesses. During the economic expansion of the 1990s, large US multinational corporations—which employ an average of about 1,000 workers each in the United States—created jobs more rapidly than other companies. This was because they dominated computer and electronics manufacturing, the sector that drove much of that boom. During the more recent expansion of 2002–07, most of the net new jobs came from local service sectors, such as health care, construction, and real estate—which comprise both large and small businesses.

[yes, the jobs created in 2002-2007 had obviously been in response to policies oriented towards inflating the real estate bubble.

I'd like to add that the current weak job conditions in the small business sector had been a product of uncertainties from ambiguous policies, according to the Wall Street Journal, ``Last year "was a very difficult year for small business," said NFIB chief economist William Dunkelberg. "Continued weak sales and threatening domestic policies from Washington have left small-business owners with little to be optimistic about in the coming year."]

3. High-tech jobs will solve the problem.

There is a lot of talk these days about green businesses, biotechnology, and other emerging industries that will create the jobs of the future. While they are obviously part of the solution, these industries are too small to create the millions of jobs that are needed right away. The semiconductor and biotech industries, for instance, each employ less than one-half of 1 percent of US workers; clean-technology workers, such as those who design and make wind turbines and solar panels, account for 0.6 percent of the workforce.

We’ll be able to generate significant numbers of new jobs only by spurring broad-based job growth across the economy, particularly in big sectors such as retail, wholesale, business services, and health care. High-tech innovations will help employment grow over the long term, as new technology spreads throughout the economy and transforms other, larger sectors. For example, while the semiconductor industry alone doesn’t account for much US employment, the computer revolution has fueled the growth of other industries such as retail and finance; similarly, the clean-technology business by itself doesn’t employ many people, but its developments could transform a big sector such as energy, creating new business models and new jobs.

4. Higher productivity (when an economy produces more goods and services per worker) kills jobs.

Not so. While productivity growth means that individual companies may need fewer employees in the short term, it spurs long-term gains in the economy as a whole. Since the industrial revolution, increasing worker productivity has brought rising incomes, higher profits, and lower prices. These forces stimulate demand for consumer goods and services and for new plants and equipment—fostering, in turn, industry expansion and job creation.

Take cell phones. Even 15 years ago, they were big, unwieldy, expensive, and worked only in limited coverage areas. But as new technologies enabled workers to produce phones and provide service more cheaply, the industry took off. Cell phones are now ubiquitous, and this has created jobs not just among phone makers but also among retailers, service providers, and a new industry of developing and selling applications for smart phones.

5. Increasing exports will revive manufacturing employment.

Maybe for some companies in some industries, but not for the economy overall. While it’s painful to accept, reducing unemployment is not mainly about regaining the jobs that have been lost. Sure, rising exports will cause some factories to scale up again, and many laid-off workers will be called back. But most new job growth will come from other sectors.

History shows that recessions—particularly those that follow a financial crisis—accelerate the growth or decline already underway in industries. In this recession, for example, the auto, financial-services, and residential-real-estate industries have contracted significantly and won’t regain their peak employment anytime soon.

[that's because these areas constituted the concentration of the boom or malinvestment phase]

An increase in exports may stem—but will not reverse—the multidecade decline in manufacturing employment. In today’s developed economies, net growth in new jobs doesn’t come from manufacturing; it comes from service industries. Fortunately, boosting exports creates jobs in supporting service industries, such as design, trucking, shipping, and logistics.

[Some will call these the recalculation or a transitional phase where the economy tries to figure out where to reallocate resources following the market clearing process from the recent recession or bust.

However, what McKinsey's Manyika seems to imply is that policies aimed at directing public resources for job creation to specific sector/s do not guarantee solutions to the present dilemma. Hence the unintended consequences is that these could lead to waste.

Said differently, let the markets decide where investments should be and jobs will eventually follow.

As Ludwig von Mises wrote, ``Profits go to those who succeed in filling the most urgent of the not-yet-satisfied wants of the consumers in the best possible and cheapest way. The profits saved, accumulated, and plowed back into the plant, benefit the common man twice. First, in his capacity as a wage earner, by raising the marginal productivity of labor and thereby real wage rates for all those eager to find jobs. Then later again, in his capacity as a consumer when the products manufactured with the aid of the additional capital flow into the market and become available at the lowest possible prices."]

Thomas Woods: Why You've Never Heard of the Great Depression of 1920

A great presentation from economist and author Tom Woods on how the unheralded Great Depression of 1920 had swiftly been resolved, the difference with the Japanese experience also of the 20s and the relevance of the Austrian Business Cycle. (source: Mises media)

Estonia’s Free Market Model And The US 1920-1921 Depression

First of all I’d like to thank Mr. Kristjan Lepik for his patronage and on adding his priceless thoughts on Estonia.

Mr. Lepik writes,

``Estonia has taken a rather different crisis-management approach than Western world (US, Western Europe et al) – no government stimulus, very low government debt (only around 10% of GDP) and no bailouts. Therefore the steep GDP drop in 2009 (around -15%), if US would have no stimulus or bailouts, the GDP would be surely negative as well.

``I think that Estonia has taken the quick and painful way, whereas a lot of countries have gone the route which may be more painful in the end – big budget deficits must be paid back at some point (probably higher taxes globally).

``I was really negative about Estonia’s outlook in 2006 (as you all know, that is not a popular thing to do), the economy overheated badly. But the normalizing process has been very effective after that, gross wages have dropped around -20%, asset prices around -60%. That surely is not a pleasant process but it is helping to restore Estonia’s competitive advantage.

``The recovery will probably not be not that quick in Estonia, the normalizing process is still ongoing and unemployment has reached 15%. But looking at the macro picture, Estonia looks pretty good (should I use the term “sane” here?) compared to most of the World.”

It may be true that the normalization in Estonia could take awhile as resolving high degree of overindebtedness could pose as significant drag to economic growth as shown by the charts below by the IMF.

From the IMF

Nevertheless, I’d be more optimistic than the IMF or of the mainstream, since they would naturally be more cynical or skeptical of the Estonia's unorthodox or unconventional approach, in a world where government intervention is seen essential or as a standard.

Although I usually refrain (and equally disdain) from making comparisons with past models, my guess is that a free market resolution would have more meaningful relevance than from an interventionist approach.

What truly distorts or impedes a market from delivering its inherent process of clearing the previously established malinvestments are further interventions. And since a free market approach would have less distortions, they are likely to elicit more “similarities” or parallelism.

And on that note, the US depression of 1920-1921 experience should pertinent.

Economist Bryan Caplan in a paper on the US 1920-1921 depression wrote of how events unfolded then,(bold emphasis mine)

``In one crucial respect, the depression of 1920-21 was actually more severe than the Great Depression itself: there was a rapid decline in the price level of between forty and fifty percent within the course of a single year. As Friedman and Schwartz (1963) explain, “From their peak in May [1920], wholesale prices declined moderately for a couple of months, and then collapsed. By June 1921, they had fallen to 56 per cent of their level in May 1920. More than three-quarters of the decline took place in the six months from August 1920 to February 1921. This is, by all odds, the sharpest price decline covered by our money series, either before or since that date and perhaps also in the whole history of the United States.” (1963, pp.232-233.) The wholesale price index during the Great Depression took about three years to fall by the same amount.

``Employment and output were however not as severely affected as in the Great Depression. Of course precise unemployment data are not available for this period, but one representative estimate (Lebergott, 1957) puts civilian unemployment at 2.3% in 1919, 11.9% in 1921, and back to 3.2% in 1923. Output figures tell a similar story: one aggregate index (Mills, 1932) indexes production at 125.3 in 1919, 99.7 in 1921, and rebounding to 145.3 in 1923. As these stylized facts indicate, the second unusual feature of the depression of 1920-21 was the rapid recovery in employment and output, in sync with a swift adjustment of the real wage to its new equilibrium position. …”

Some charts from EH.net

In other words, a market based adjustment that had been swift and drastic translated to equally a rapid and dramatic recovery in 1920-1921.

And why this should come about?

Austrian economist Robert Murphy provides as a possible answer,

``After the depression the United States proceeded to enjoy the “Roaring Twenties,” arguably the most prosperous decade in the country’s history. Some of this prosperity was illusory—itself the result of subsequent Fed inflation—but nonetheless the 1920–1921 depression “purged the rottenness out of the system” and provided a solid framework for sustainable growth."

When rottenness is purged out of the system, then the recovery is likely to be relatively more robust and sustainable since the economy should reflect on market dynamics than from artificial foundations.

We end with a quote from President Warren Harding’s inaugural speech in 1921 which dealt with the crisis, (all bold highlights mine)

``We must face the grim necessity, with full knowledge that the task is to be solved, and we must proceed with a full realization that no statute enacted by man can repeal the inexorable laws of nature. Our most dangerous tendency is to expect too much of government, and at the same time do for it too little. We contemplate the immediate task of putting our public household in order. We need a rigid and yet sane economy, combined with fiscal justice, and it must be attended by individual prudence and thrift, which are so essential to this trying hour and reassuring for the future.…

``The economic mechanism is intricate and its parts interdependent, and has suffered the shocks and jars incident to abnormal demands, credit inflations, and price upheavals. The normal balances have been impaired, the channels of distribution have been clogged, the relations of labor and management have been strained. We must seek the readjustment with care and courage.… All the penalties will not be light, nor evenly distributed. There is no way of making them so. There is no instant step from disorder to order. We must face a condition of grim reality, charge off our losses and start afresh. It is the oldest lesson of civilization. I would like government to do all it can to mitigate; then, in understanding, in mutuality of interest, in concern for the common good, our tasks will be solved. No altered system will work a miracle. Any wild experiment will only add to the confusion. Our best assurance lies in efficient administration of our proven system.”

We hope that the success of Estonia's model will lead the world the way.

Estonia: A Resurgent Baltic Tiger In Defiance of Mainstream Antidote?

Andreas Hoffmann writing in Thinkmarkets sees Estonia as a returning Baltic Tiger.

Here is Professor Andreas Hoffmann (all bold highlights mine)

``the Estonian government reacted in a way to the current crisis that should bring tears of joy into the eyes of any free market economist: First, they did everything to hinder a devaluation of the Estonian kroon, as a relatively stable exchange rate to the euro is a prerequisite for euro introduction. Secondly, they did not overspend. Instead they cut wages heavily with the fall in per capita GDP – even in the public sector. And third, unlike most economies, Estonia did not sacrifice economic freedom for crisis management. Instead, officials wait for the crisis to heal the market. At the same time lower spending is assumed to bring inflation down. The crisis is seen as a chance to (readjust and) fulfill the Maastricht inflation criterion, which was impossible during the boom period.

``Thus, as Estonia allowed for an adjustment process, malinvestment from the previous boom should be dismantled soon. This should bring about lucrative future investment possibilities in an economy with solid macroeconomic fundamentals, a high degree of economic freedom and prospects to enter the euro zone. At the moment interest rates are much higher there than in the euro area and a credible fixed exchange rate assures against depreciation. These facts should attract new investors. Therefore it is likely that we soon see the return of at least one Baltic tiger."

What makes the Estonian account very interesting is that she appears to have taken an unorthodox (or outlier) approach in dealing with the recent crisis- market based adjustments that had been swift, drastic and painful. But instead of encountering a prolonged recession or even a depression, it now seems that Estonia have been revealing signs of an equally rapid and dramatic recovery.

This seems to contravene anew the conventional notion that markets, when left to their own devices ("officials wait for the crisis to heal the market") to deal with the recessions or a crisis, would cause a depression.

Even the IMF look equally impressed: ``Following recent budget measures and assuming continued fiscal consolidation efforts, Estonia could meet all Maastricht criteria, while the policy record to date provides assurances for continued stability-oriented policies. This is remarkable, as it is being achieved against the background of severe dislocations due to the crisis. Joining the euro zone would remove residual currency and liquidity risks, adding stability to the Estonian economy."

Here are some charts from the IMF...

Real Effective Exchange Rates

Real Wages and Monetary Aggregates

Real GDP and Inflation

Estonia's OMX Talinn Index (from Bloomberg) [up 36% year to date]

I'll leave it to this blog's Estonian readers to contribute to this outlook.

Cartoon of the Day: Evolution!

From Ritemail.blogspot.com

Trade Fallacies: Big Business Sucks Out Lifeblood From The Consumers

“Big Business sucks out the lifeblood from the consumers.”

It’s one of the most popular “socialist” fallacies that I only read online, but was surprised to have personally heard a variation of last week from an unexpected source.

The negative connotation is that trade signifies as a parasite-host relationship where only one party benefits from the engagement.

This represents sheer political absurdity.

Here's why.

When a person say, purchases a pair of shoes from a shoe store at a mall, he/she expects that the new pair of shoes to either replace his/her old pair or to augment the inventory of shoes-perhaps for fashion purposes or in combination with his/her clothes in order to comply with the required uniform in the workplace or for many other personal reasons (as gifts, etc..)

When a person pays to eat at a restaurant, he/she fulfills the need for nourishment, irrespective of the classification of the venue (fine dining, fast food, canteen etc.) and or the variety of food served and consumed.

When a person buys a car from the car dealer, he expects that the new car to accomplish his/her mobility goals or social esteem needs.

In other words, when people voluntarily exchange money for certain goods or services they expect to directly benefit from the exchange-either to enhance the person’s wellbeing by expanding utility (or increasing convenience by usage) and or for reputation (self esteem) motives and or social (gifts, charities, donations, Keeping up with the Jones', etc...) incentives.

In addition, the presence of competition expands the consumer’s array of choices. This means producers will have to earnestly compete with each other to please the consumer’s desires by offering the most desirable products or services in terms of prices or through quality or in some forms of intangible advantages or a combination thereof.

Of course, the reward from having to meet the consumer’s needs or wants translates to the ultimate goal- profits.

And one must not forget that producers or service providers are themselves consumers. In short, people produce in order to consume.

So nowhere in the above circumstances reveals that trade has been a one-sided affair or a parasite-host relationship because both the sellers and buyers directly benefits from the voluntary exchange, aside from assuming reciprocal roles.

In the US, the steady entrenchment of life enhancing technology enhanced tools or equipments essentially translates to an increase in the standards of living (see chart above from AOLnews), is a product of free trade.

As W. Michael Cox chief economist of the Federal Reserve of Dallas wrote, ``As the great economist Joseph Schumpeter put it: "Queen Elizabeth owned silk stockings. The capitalist achievement does not typically consist of providing more silk stocking for queens but in bringing them within the reach of factory girls for steadily decreasing amounts of effort."

``Innovation and trade continually drive down the real cost of goods and services and increase the productivity of each hour of work. As this capitalist engine churns onward, the scarcity that plagued mankind for millennia has given way to the abundance that's the foundation of today's vast middle class." (bold emphasis mine)

This should well apply to economies that are also responsive to freer trade. And this phenomenon do not escape the Philippines.

Unfortunately such intangible benefits can’t entirely be captured by statistical GDP. And it is due to the ambiguities of the observable but unquantifiable benefits that has prompted liberals or socialist to argue based on fallacious premises.

Trade As Wealth Drain?

The other negative implication about the misleading sucking out the life of consumers is the impression that the “wealth” of consumers are allegedly being drained by businesses.

This is another utter nonsense.

Money isn’t wealth. Money is a medium of exchange. Regardless of whether people acquire things by falling victim to boom bust policies by loading up on intractable debt or not isn’t the issue. Inflationism is likewise not an issue here.

The issue is that people voluntarily conduct exchanges in the expectations that they would directly benefit from it, regardless of how it is funded.

When people undertake trade, basically people do not trade money for goods, but on their output or the product or services which they represent. Money only serves as a proxy for one’s output or an alternative instrument to facilitate for an exchange of goods and services.

So the money spent by a local bum in the Philippines, which may come from remittances by an overseas worker benefactor (usually a parent/s) is pretty much the same money spent by a spoiled brat from a wealthy parent or even from a politico sponsor. They represent some forms of product or services that have been converted into money and used for the exchange.

In other words, the idea that big business bleeds dry the consumers in a competitive marketplace is pure hogwash.

Taxes And Political Concessions As Wealth Suckers

Let me tell you where the consumer’s wealth gets truly sucked out.

The marketplace represents as a platform for continuous human actions of voluntary exchanges where consumers and producers employ choices for the ultimate goal of having to directly meet a specific end or goal or benefit. Hence voluntarism translates to mutually beneficial actions.

When the voluntarism is stripped out of the equation, then consumers are essentially held hostage to abide by the conditions imposed by law. Hence consumers would be forced to comply with the service or goods that they normally would not likely accept in the context of the marketplace.

Taxes are fundamentally the best example of wealth sucking activities employed by governments on the consumers.

Taxes are coercive or not voluntary. There is no choice for consumers but to pay for services it may or may not want, otherwise non-conformity means penalty (fines, legal harassment or at worst incarceration).

Taxes don’t have direct specific benefits to each taxpayer. Unlike trade where the benefits are direct and mutual, we use some but not all the privileges from government funded (public goods) projects, e.g. we don’t use all government most constructed roads do we?) In short, while the supposed benefits are assumed by most people as direct, they are realistically indirect.

Since government is a political entity then its tax funded expenditures are similarly deployed politically, hence taxes end up mostly to:

-funding pet projects of elected officials for vote generating purposes
-subsidizing liabilities of vested interest groups
-the pockets of these officials and or many of the bureaucrats involved on them
-expand bureaucracy
-finance worthless projects or projects of little market value
-dispense favors to political allies via behest loans etc…
-fund substandard and overpriced projects
-redistribute resources from productive to non-productive segments of the society
-and many others

In short, where the alleged exchange (tax for public goods) is imposed by decree, the cost benefit ratio for the consumers is heavily skewed towards the cost. So except for bureaucrats and politicos, people essentially pay more for taxes than they benefit from it. Thus, forced compliance by the consumers, where the cost is apparently larger than the benefits, equals to a net drain to our wealth.

Of course one may add that politically based economic concessions (economic rent seekers) or legislative decree based “private” monopolies which eludes competition and restricts consumers to pay for overpriced and inefficient goods or services serves the same function, it is a net drain for capital accumulation, and thus, economic wealth.

In short free trade benefits the economy's wellbeing and adds to wealth, while government imposed tax for service and political monopolies function as a net drain on wealth.

Don't fall for vicious political propaganda.

Manufacturing Turnaround As Lead Economic Indicator

For us, manufacturing conditions signify as a prime indicator to signify the state of an economy. This also applies to the world.

According to the Economist, ``SURVEYS of purchasing managers indicate that manufacturing industries in most of the world’s big economies are growing. In big emerging economies such as Brazil, China and India, the indices compiled by Markit, a provider of financial information, were well above 50 in January, indicating robust growth. In each of those countries manufacturing was still shrinking in January 2009. There has also been a pronounced turnaround in America, where the Institute for Supply Management’s index for January was 58.4, in contrast to 35.5 in January 2009. Manufacturing is also expanding in Germany, France and Britain. But it is still shrinking in Greece and Spain, though much less markedly than a year earlier."

From Danske

While manufacturing conditions may slow from their recent turbocharged activities, they aren't likely to "double dip" this year as alleged by perma bears-not when the steep global yield curve is likely to produce credit traction by the year end.